Restatements Surged in 2005, Says Study

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Restatements are busting out all over. The number of revisions of financial reports by publicly traded companies surged to a record 1,295 in 2005, nearly double the previous year’s mark of 650, according to a new study by Glass, Lewis and Co., a corporate-governance research firm. The tally is also more than triple the total in 2002, the year the Sarbanes-Oxley Act (Sarbox) was passed.

According to the study, 1,195 companies — or 8.5 percent of all U.S. corporations — filed a restatement. That compares with 4.5 percent the previous year. From 1997 through 2005, public U.S. companies filed 3,642 restatements to correct accounting errors. That’s about 30 percent of all public U.S. companies during the past nine years.

“When so many companies produce inaccurate financial statements, it seriously calls into question the quality of information that investors relied upon to make capital-allocation decisions,” noted the report. “Investors need unbiased, competently prepared financial statements to make these decisions efficiently.” The total number of 2005 restatements works out to one restatement for every 12 public companies — up from one for every 23 in 2004.

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The research firm firmly disagreed with company officials who blame the overreaching requirements of Sarbox for the large number of restatements. “It’s precisely because of the heightened auditing standards mandated by Sarbanes-Oxley that investors today are getting a true sense, finally, of just how much work remains to be done before they can feel confident about the accuracy of the financial statements prepared by corporate managers.”

In fact, the report said that last year’s volume of restatements likely would have been even higher had U.S. regulators not agreed to make an exception for companies with stock-market values of less than $75 million and extend their deadlines for compliance with Section 404 of the act into 2007. According to the study, the smallest companies, measured by market capitalization, were nearly twice as likely to restate as the largest companies: “Smaller companies are where most of the problems historically have existed.” Section 404 deals specifically with a company’s internal controls over financial reporting.

The data also called into question the Securities and Exchange Commission’s decision to postpone implementation of Section 404 on several occasions, and the proposal by the SEC Advisory Committee on Smaller Public Companies to roll back 404 rules for the vast majority of publicly owned companies.

Further, the study pointed out that more than half of all restatements in 2005 were by companies that have disclosed at least one material weakness. Of the 640 restatements by companies with disclosed material weaknesses last year, 42 were by companies that restated twice in 2005.

Glass, Lewis also found that so-called stealth restatements are on the rise — 14 percent of all restatements were filed without amended filings, Form 8-K filings, or other public announcements.

The study broke the data down into 12 error categories, the most common by far being expense recognition, which accounted for nearly 450 restatements, or 25 percent of the total. More than half of last year’s expense-recognition errors stemmed from improper lease-accounting practices.

In 2005, 249 companies filed restated financials to correct their accounting for leases: “Many of these companies also had misclassified items on their cash-flow statements.” Even without the wave of lease-accounting fixes, improper expense recognition still would have been one of the leading causes of restatements in 2005.

After expense-recognition errors, the next most common restated items were financial-statement misclassifications, followed by equity-related errors, comprising 18 percent and 13 percent of all identified errors, respectively.

Interestingly, companies audited by the smallest audit firms were six times more likely to restate than companies audited by the Big Four. The auditor with the highest restatement rate (12 percent) was Grant Thornton; the Big Four auditor with the highest restatement rate (7.1 percent) was KPMG.